Capital Flows to Latin America: Recent Developments

External financial conditions have improved significantly for Latin America and the Caribbean and other emerging market regions. Since the lows reached in early March 2009, U.S. equity and U.S. High Yield markets have rebounded. Volatility has receded as a result of growth reemerging in most countries in the second half of the year and financial markets are seeing a bounce in risky assets. The closely watched Chicago Board Options Exchange (CBOE) Volatility Index (VIX), a key measure of market expectations of near-term volatility and a barometer of investor sentiment, fell below 30 in May and in October reached 20.69, its lowest value since August 2008.

Improved market conditions have been reflected in declining debt spreads, increased debt issuance and in a pick up in equity flows to the Latin American and Caribbean region. The Latin component of the JPMorgan EMBI+ has tightened 386 basis points since reaching a peak in November 2008. Following a dry spell in the second half of 2008, Latin American bond issuers have been active since the beginning of 2009, particularly in September and October. Total international Latin American and Caribbean issuance year-to-date is US$ 62 billion, with US$ 47 billion being issued since June. Newfound investor comfort has trickled down the ratings scale (given the lack of sufficient supply), with sub-investment grade issuance also showing signs of revival. Inflows into Latin American equities have also picked up since the beginning of the year, with the Morgan Stanley Capital International (MSCI) Latin American Index gaining 78% form January to September 2009. In comparison, the MSCI for emerging markets gained 61% in the same period, while the G7 gained 20%.

Recent positive global macroeconomic data has thus given market participants hope for a turnaround, with risk tolerance increasing as a result. As countries in the region come out of the crisis with comfortable fiscal and public debt positions, tight banking regulation, and high levels of international reserves, the Latin America and Caribbean region has emerged as an attractive destination for investment, leading equity prices to rise and credit spreads to narrow. As a result, the outlook for private capital flows has improved significantly since the second quarter. Net flows to Latin America are now projected to be just shy of US$ 100 billion in 2009, down from US$ 132 billion in 2008 and US$ 229 billion in 2007, according to the Institute of International Finance (IIF).

Capital flows to the region will likely remain strong in 2010, with private inflows expected to increase to US$ 150 billion according to the IIF, as a result of the significantly improved global financial conditions and risk appetite, higher global liquidity, and Latin America's relative attractiveness to investors. Many emerging countries are now edging towards imposing capital controls to stop short-term speculative inflows driving their currencies higher amid concerns about the growth of an emerging market asset bubble. Brazil for example, has recently imposed restrictions on the inflow of money destined for financial assets (a 2% tax on foreign investment in equities and bonds announced in October and a 1.5% tax on American Depositary Receipts announced in November).

However, although global liquidity will remain high in the upcoming quarters, favoring Latin American assets, market anxiety about the timing of exit strategies from the huge fiscal and monetary support provided by governments around the world represents a significant risk to the region's outlook and market dynamics in the next year.